The economics of the informal sector: A simple model and some empirical evidence from Latin America

This paper presents the view that the informal economy arises when excessive taxes and regulations are imposed by governments that lack the capability to enforce compliance. The determinants and effects of the informal sector are studied in an endogenous growth model whose production technology depends essentially on congestable public services. The model concludes that changes, both in policy parameters and the quality of government institutions, that promote an increase in the relative size of the informal economy will also generate a reduction in the rate of economic growth. The paper then uses data from Latin American countries in the early 1990s to test some of the implications of the model and to provide estimates for the size of the informal sector throughout these countries. The empirical approach consists of identifying the size of the informal sector to a latent variable for which multiple causes and multiple indicators exist. The size of the informal sector is found to depend positively on proxies for tax burden and labor-market restrictions, and negatively on a proxy for the quality of government institutions. Furthermore, the empirical results suggest that an increase in the size of the informal sector negatively affects growth by, first, reducing the availability of public services for everyone ill the economy, and, second, increasing the number of activities that use some of the existing public services less efficiently or not at all.